Tuesday, September 27, 2011

In a previous blog we discussed the importance of exploiting processing capacity available today to become acquainted with a stock’s business model and strategy. This reveals how a stock plans to create shareholder value starting with the top line sales revenue. Revenue results from managing the external Opportunities and Threats identified from a SWOT analysis, and bottom line earnings from sales revenues result from managing the Strengths and Weaknesses internal to the organization.

Financial Statement Analysis is a major tool used to identify and manage these Strengths and Weaknesses. It starts by consider the results from the three major firm decisions: Investment, Financing and Dividend as described from the following figure:

Source: Chapter.3 Valuation Tutor.

The top line, Fundamental growth per share (ROE * RR), reflects the results from three major business decisions: Return on Equity (ROE) result from the Investment and Financing decisions and the Retention Ratio (RR)/per Share results from the Dividend decision.

ROE further decomposes via the DuPont analysis into three major components, Profit Margin, Asset Turnover and Financial Leverage. The firm’s profit margin results from how efficiently the firm is converting Sales into Operating Income. Asset Turnover results from sales revenue, working capital management and the firm’s degree of operating leverage. Financial Leverage results from how the firm finances these operations. Traditional DuPont highlights these relationships and is often further refined into a DuPont Burden Analysis, designed to sharpen the decomposition further in terms of it’s sensitivity to major business decisions.

Consider, conducting a burden analysis for IBM in comparison with HPQ:

The refinements sharpen the measures by first measuring profitability relative to operating income to separate out taxes and interest expense. Burden analysis is useless without a comparison and we know from a previous blog that HP is attempting to emulate IBM’s business strategy. That is, by shifting focus away from lower margin commoditized products towards providing higher margin services. By selecting both IBM and HPQ in the above “Select Subset of Stocks” and clicking on Calculate for All automatically performs the DuPont burden analysis on the subset of stocks selected.

Immediately, this reveals that IBM is outperforming HPQ in terms of both ROA and ROE, and the driver of ROA is a superior profitability margin. The only ratio looking better for HPQ is the Asset turnover ratio which we examine further next.

First, Working Capital Management reveals one immediate driver of the better Asset Turnover. The cash conversion cycle for HPQ is shorter than IBM’s 67 days:

Source Valuation Tutor Working Capital Analysis

Looking at the drivers of the Cash Conversion Cycle reveals that an important part of IBM’s current strategy in the current economy is to extend credit to it’s clients so that the days to collect receivables is 103 for IBM versus 62 for HPQ.

Second, we look at the Degree of Operating Leverage for IBM versus HPQ. This is a measure of how sensitive each company’s Operating Income is to Sales. The higher the more sensitive EBIT (Earnings Before Interest and Taxes) is to changes in Sales Revenue. In turn this will drive both operational risk as well as asset turnover numbers in a company. Both IBM and HPQ are similar along this dimension (DOL is just over 2.0 for both companies). However, the big difference arises from the Contribution Margin Ratio being much higher for IBM:

Source Valuation Tutor Activity Analysis.

Again this reinforces the success of IBM’s Business Strategy which is also immediately revealed in the relative importance of the different sales revenue components for IBM and HPQ (Source recent 10-K’s income statements screenshot from Valuation Tutor):

IBM has eliminated it’s lower margin products to focus on Services and Financing whereas HPQ is currently attempting to implement this type of shift.

Impact of Dividend Decision Differences

The other major difference between the two companies that indirectly results in the different asset turnover numbers is the dividend decisions. IBM is very aggressive with respect to paying dividends via Treasury stock purchases. That is, re-purchasing it’s own shares is an important part of IBM’s dividend decision. This enhances the per share values of ratios and in particular both Assets and Sales per share. The increased asset utilization for HPQ’s DuPont relative to IBM largely arises from relatively higher asset per share number for IBM compared to their Sales per share.

This strategy can be an important driver of building shareholder value so long as the share repurchases come from a stock’s Free Cash Flow to Equity. This is where IBM really shines relative to HPQ because IBM can afford to implement a more aggressive Treasury stock strategy than it’s competitor because it generates much larger amounts of Free Cash.

Source Valuation Tutor Price Ratios (Chapter 5)

As a final check for assessing what level of confidence we place on the reported financials from each company, we look at each stock’s Quality of Earnings. The usual measurements of this are relative to the Balance Sheet, Cash Flow and Income Statements. Here both IBM and HPQ appear to be very solid on this front. For the case of IBM this reveals:

Source Valuation Tutor (Chapter 5):

In particular, both IBM and HPQ have negative % Operating Accruals which is a good sign!

So overall, the financial statement analysis for IBM and HPQ reveals that the attraction of IBM’s
business strategy is it’s impact upon Operating Earnings. This in turn generates higher free cash
flows and allows for a more aggressive dividend decision. The bottom line is that IBM has been
much more successful for building shareholder value than HPQ especially during these difficult
economic times.